CFDs - Basics

A Contract for Difference (CFD) is a derivative product that allows an investor to trade shares of stock without having to pay the full cost of owning the stock. A CFD represents an agreement between a buyer and a seller to exchange the difference in value of a trade between its opening and closing values.

Since CFD investors are required to deposit only a fraction of the overall value of the trade, they are able to make much larger investments than if they had to purchase the actual shares. Similarly, if the shares lose value, CFD investors face greater losses than those investors that fully own the same number of shares.

A simple example:

In September an investor agrees to buy 500 Halifax shares at £6.00 (total value of £30,000), and places the 10% margin deposit of £3,000. In November, when the price of the Halifax increases to £8.00, the investor decides to sell the shares. This results in a gross profit of £10,000 (i.e. £40,000 less £30,000), and the initial margin deposit is also returned to the investor. (Note: this is a simplistic example designed to explain the concept of CFDs. If the price of the shares moved against what the investor anticipated, a loss in excess of the funds deposited could be incurred. Please see below for an explanation of costs and risks of CFD trading.)

Advantages

• Increased leverage: CFD investors are able to control up to 10 times the number of shares than an outright purchase using the same amount of capital. There is a potential for greater profits if the investor correctly anticipates the movements of the stock price – and, a greater risk of loss if the position moves against the investor’s prediction.
• No stamp duty: Stamp duty on CFD transactions is not required within the jurisdictions that require stamp duty on share trading. (Current tax laws subject to change.)
• Sell short with ease: Combined with increased leverage, selling short allows investors to take advantage of both falling and rising stock prices, trade within shorter time frames and thus profit from small movements in the underlying stock prices.
• Risk management: CFD investors have the ability to protect a multinational portfolio against short-term market falls by selling sufficient CFDs to cover their exposure. The profit generated from a market decline should offset the loss incurred by the portfolio. Increased leverage: CFD investors are able to control up to 10 times the number of shares than an outright purchase using the same amount of capital. There is a potential for greater profits if the investor correctly anticipates the movements of the stock price – and, a greater risk of loss if the position moves against the investor’s prediction.
• No stamp duty: Stamp duty on CFD transactions is not required within the jurisdictions that require stamp duty on share trading. (Current tax laws subject to change.)
• Sell short with ease: Combined with increased leverage, selling short allows investors to take advantage of both falling and rising stock prices, trade within shorter time frames and thus profit from small movements in the underlying stock prices.
• Risk management: CFD investors have the ability to protect a multinational portfolio against short-term market falls by selling sufficient CFDs to cover their exposure. The profit generated from a market decline should offset the loss incurred by the portfolio.

Cost Considerations

• Commission: Varies by market, size and frequency of trading. Industry average is around 0.25%.
• Interest: Daily interest will be charged for as long as the investor holds the CFD, because the broker has effectively financed the value of the trade. Interest rates fluctuate and investors should consult with their account executive to determine current rates.
• Dividends: Investors holding purchased CFDs earn 90% of any dividend payment due on the underlying shares. Investors who hold sold CFDs will be charged 100% of any dividend payment.
• Margin requirements: Initial margin is 10% upwards, depending on both the volatility of the market and the volatility of the individual stock. Positions are marked to market, daily, and the initial margin must be maintained. Therefore, if positions move against the investor, he/she may be required to make further deposits. Investors are required to meet the full value of running losses.

Other Considerations